Anurag Wakhlu's  Instablog

If you are in the camp that thinks that all this government spending and a resurgent global growth (after this recession is over) will cause an above average inflation scenario, and want an investment strategy that could help in such a scenario, then read on.

There are several ways one can hedge against inflation. One can invest in commodities, gold, oil, and the more traditional US TIPS. However, each comes with its own flavor of risk and a variety of factors that can cause the returns of the strategy to differ from just “Breakeven inflation” (term used interchangeably with “inflation expectations”).

What is breakeven inflation (BEI)? The difference between the nominal yield of say a 10 year Treasury, and that of a 10 year inflation indexed bond is a measure of expected inflation. Technically speaking, BEI is the rate which will equate the return on the indexed bond to the nominal bond. The current 10 year BEI is about 2%, which is close to the long term average.

So how does one invest in a BEI strategy using equity ETFs? Simply buying a TIPS ETF, though good for hedging inflation in general, may not track BEI well because TIPS (bonds) are affected by, among others, interest rates, which can rise once the economy gets back on its feet. For example, investing in the TIP ETF around Feb of this year ($99), through July end would have given a return of slightly under 2% ($100.4). The BEI in the same period went from 1% to 2% (100% change). The ETF strategy outlined below would have returned 100% ($1 to $2). All numbers rounded for simplicity.

What is the trade (do not skip the associated risks part of this article)? One way to implement it is to long (buy) TIP and short (sell short) IEF in a ratio of 1:1. Your net investment is about 1$. The way to make money on it is to lever it up. Leverage is, ironically, a 2X levered four-letter-word. But you can’t blame the knife for the crime. The leverage depends on your risk appetite and capital. The performance of this trade vs the 10-year BEI is shown below, scaled to show the similarity. The second chart shows the daily change in the BEI and the trade. As you can see, it has tracked the BEI trend reasonably well this year, with a daily percentage change that is similar too (except when BEI is near zero).

 

 

Other ways to implement it would be to long IPE or WIP (World inflation), and short the various long-Treasury ETFs such as SHV, IEI, TLH, SHY, TLO with IPE, or BWZ, BWX with WIP.

You could get more sophisticated by duration matching the 2 sides of the trade, but given the variability in tracking using ETFs anyways, that may be overkill.

Note, if you can't short the ETFs, you could go long the short-Treasury ETFs such as TBT or PST. But then your ROI is dramatically reduced (less than 1% in the above example) to the point of being an exercise in futility, unless you trade on margin (I wouldn't recommend leverage + margin, that is a recipe for bankruptcy).

Also, if you have a deflation view, simply reverse the above trade.
 

What are the risks? We may not have high inflation, or worse, have deflation. In that case you lose on both sides of this trade (magnified by leverage). Bad scenario. Or, the trade may not track BEI in terms of direction and/or magnitude of return (as was the case late last year). Note: past tracking is no guarantee of future tracking. When the BEI is near zero, the daily change doesn’t track it even remotely. As with other leveraged ETFs, this is not a buy and hold strategy, but better suited to short term bets on BEI, which in itself is a risky bet given the uncertain state of the markets. Short term technical factors in the interest rates space can make this trade very volatile. This trade is not suitable for every investor.

 

Disclaimer: The opinions, trade and views expressed above are entirely of the author and do not in any way reflect those of their employer. The author doesn’t have this trade on, but is long TIP and WIP.